What is the primary purpose of a stock split? Should you buy a stock because it might split? It may seem like a gift to some, but there is little evidence that you benefit in any meaningful way. That’s why understanding the ins and outs of splits is vital before you go out and invest your money in stocks.
Table of Contents
- What Is a Stock Split?
- How Do Stocks Split?
- Stock Split Examples: Alphabet (NASDAQ: GOOGL)
- Can a Stock Split Be Bad?
- Reverse Stock Split Example
- Frequently Asked Questions
What Is a Stock Split?
A stock split is when a company increases or decreases the number of shares outstanding. It is often a mechanism used to boost the stock’s liquidity. Shares have performed well enough to be at a reasonably high valuation, and the company can afford to see its stock price slashed.
You might naturally think that SS’s dilute the value of the shares. However, if a split makes it cheaper for investors to buy the stock, it also makes it cheaper for the company to buy back its shares.
For retail investor sentiment, a stock split is generally a net positive. First, allowing more investors to buy the stock is a good thing. Companies like to reward their shareholders; providing them with more stock is one way they can do it.
Why Might a Company Split It’s Stock?
They are a major event for investors to look forward to, even if the value of the stock doesn’t change. Wait, what was that last part? The value of the stock doesn’t change? But surely, when there are more shares, the value does change. It does, and it doesn’t. Let’s think of a company as a pizza cut into ten slices.
If the company has a 2-for-1 stock split, we’d now have twenty slices. But the size of the pizza itself hasn’t changed.
You may own twice as many shares as before, but you’re generally not wealthier.
Stock Split Psychology
What stock splits generally do is play with the psychology of investors. Let’s be honest. Most investors are greedy by nature. We’re investing money to make more money, hopefully. So many investors think of more shares as better.
We usually see a bullish spike in the stock’s price as buying pressure sets in before the split occurs. But don’t be fooled: the size of the pizza remains the same.
For starters, one good reason a company may split its stock is when the market price per share is so high that it becomes unwieldy when traded.
In situations like this, when the share price is ridiculously high, small investors may be deterred from buying the shares. But a split will make shares more affordable for more people. It’s important to keep in mind two things. First, a stock split causes a decrease in the price of individual shares.
Second, it does not cause a change in the company’s total market capitalization. Stock dilution does not occur. Our trading service is here to teach you how to take advantage of all market conditions.
An Example of a Stock Split in Action
Humor me for a moment here. Let’s turn back to Facebook’s infancy and say they issued 100 shares at $50 a share. When you do the math, that’s a $5,000 market capitalization (100 x $50).
To calculate the new price of your 200 shares, divide the market capitalization of $5,000 by 200, and you get a price of $25.
Even though the number of shares increased and the value decreased, the market capitalization is the same as before the split.
Any Split Ratio Is Possible?
More often than not, we tend to see ratios of 2-for-1, 3-for-1, and 3-for-2 splits. However, any ratio is possible.
However, Companies use splits of 4-for-3, 5-for-2, and 5-for-4, though less frequently. Likewise, investors sometimes will get cash payments instead of fractional shares.
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How Do Stocks Split?
What is the primary purpose of a stock split? And how do they split? A company decides to trade more shares at a lower price for the existing shares held by shareholders. The new liquidity of the stock mirrors the new price. As a result, shareholders and investors don’t lose their value.
Do Splits Lead to Higher Stock Prices?
Some claim that splits lead to higher stock prices, but research does not support this. Indeed, a split often happens after a run-up in share price, but that’s not what causes the run in the first place.
Momentum investing suggests that the upward trend would continue regardless of the stock split.
In any case, SS’s do increase the liquidity of a stock. Mainly because there are more buyers and sellers for ten shares at $10 than one share at $100.
On the other hand, some companies have the opposite strategy; they refuse to split the stock, which keeps the price high, thereby reducing trading volume. One notable example of this is Berkshire Hathaway.
Company Hesitation to Split Their Stock
Perhaps one of the best examples of a company that rarely desires to split its stock shares is Berkshire Hathaway. At the end of July 2018, Class A shares were trading over $303,000 each.
You read that right: $303,000 each. However, the more accessible Class B shares were trading at around $200.
The Class B shares were created as a compromise between Buffett, who did not want to split shares, and investors who wanted to purchase shares at a reasonable price.
In 2010, the company split Class B shares 50-1 but has never split Class A shares.
The Psychology Behind Stock Splits
One of the thoughts is that a split is a signal to purchase shares. If many traders and investors think that a split will increase the share price, they purchase the shares, and the price tends to increase.
It’s like the chicken or the egg, which came first? Others interpret a stock splitting as a sign of management confidence in the company’s prospects.
Stock Split Examples: Alphabet (NASDAQ: GOOGL)
The first major company to announce a split this year was Alphabet. It is the parent company of Google, YouTube, and the Android smartphone. By market cap, it is the fourth biggest company in the world and the third largest in the US.
It is also one of six companies globally with a current market cap of over $1 trillion. So, this year’s split will be the first real one in the company’s history.
With shares currently trading at around $2,500 per share, it is easy to see why the company wanted to make the stock more accessible. This year, As a result, Alphabet’s split will be a 20-for-one split in July.
1. Amazon (NASDAQ: AMZN)
Shortly after Alphabet announced its split, fellow tech giant Amazon joined the fun.
The announcement was somewhat of a shock as Amazon has avoided splitting its expensive stock for years.
Many believed that former CEO Jeff Bezos did not want to split the stock, but the new CEO, Andy Jassy, had a different idea.
Amazon split its stock thrice during the dot-com bubble years in 1998 and 1999.
This year’s SS for Amazon will also be a 20-for-one split and will take place in June. Some believe Amazon and Alphabet are splitting their stock to be included in the Dow Jones Industrial Average.
2. Tesla (NASDAQ: TSLA)
Less than two years after the company’s first-ever stock split, Tesla announced another one is coming this year. In August 2020, Tesla split its red-hot stock 5 for 1.
This year’s split still needs to pass a vote later this year, but chances are this vote will pass. Unfortunately, no other details have been released, so nobody knows the ratio or date it will take place.
Most believe it will be a 4 for 1 or 5 for one stock split, given its current price of just above $1,000 per share.
3. GameStop (NYSE: GME)
The lead meme stock also turned heads earlier this year when it announced its stock split. But, of course, few things excite retail traders more than a split, so GameStop is certainly playing to its crowd.
GameStop’s stock split is going to be slightly different. It’ll be in the form of a dividend. Most other details have yet to be released as a vote needs to pass at the annual shareholder meeting.
The proposed split would increase the number of shares from 300 million to 1 billion. However, with shares trading at just over $140, the split likely won’t be a significant ratio.
4. Shopify (NYSE: SHOP)
The most recent company to announce a split is Shopify. The Canadian eCommerce giant was one of the hottest stocks over the past few years. So far in 2022, shares of Shopify are down more than 64% as the tech correction has hit the company hard.
Shopify announced its split would be a 10-for-one split and take place at the end of June. This will be the first official SS in Shopify’s history.
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Buy Before or After the Stock Splits?
It’s a great question and one that I see frequently being asked. Understandably, the natural inclination is to buy the stock ahead of its split. But with so many people thinking the same way, you’ll likely be buying the stock at its high.
A stock split isn’t a business event, so it can artificially raise the valuation price. The translation of this is that there is a good chance the stock price will fall post-split.
But for some reason, investors think holding a stock through the split is better than buying the shares post-split. So, for example, buying one share of Alphabet will now receive twenty in July.
But nobody wants to buy twenty shares in July. They want to see their single share split. There isn’t a tried and true time to buy a stock that will split. Some will say buy it before to gain the value of the surge into the split.
While some will say buy the stock post-split when the price has leveled off. This is something that is totally up to the individual investor. As I said before, it doesn’t matter when you buy the pizza. It just matters that you own it.
Can a Stock Split Be Bad?
Absolutely. Occasionally, you will see a company implement a reverse stock split. You’re right if you assumed this was the opposite of the abovementioned split. A reverse split is often used to prop up a stock’s price since the price rises on the split.
This means that each slice of the pizza is made larger. So, think of our ten-slice pizza as now being a five-slice pizza. While that’s not necessarily bad when it comes to pizza, when it comes to a stock, it can be concerning.
Distressed companies who want a higher stock price often use reverse splits.
Companies with low share prices mainly want to increase prices for several reasons. First and foremost, it could be to raise their profile and gain respect.
Or, it could be to prevent the company from being delisted. If you didn’t already know, many stock exchanges will delist a company if its stock falls below a certain price per share.
Reverse Stock Split Example
A reverse stock split is often a sign that something is wrong, and caution is advised when considering this type of investment. For example, in a reverse 1-for-5 split, 20 million outstanding shares at 50 cents each would now become 5 million outstanding at $2.50 per share. In both cases, the company is still worth $5 million.
I’m sure you’ve heard of Citigroup Financial. In May 2011, they did a 1-for-10 reverse split to reduce their share volatility and discourage speculator trading.
The split reduced the number of its outstanding shares from 29 billion to 2.9 billion. When implemented, the share price increased from $4.52 to $45.12, and every ten shares an investor held were replaced with one share.
Like the examples above, the company’s market cap remained the same ($131 billion).
- The board of directors of a public company issues a stock split
- An increase in the number of shares in a company
- The primary motive is to make shares seem more affordable to small investors even though the company’s value doesn’t change.
- When a split occurs, the market cap of the company stays the same
- It can be used to attract investors due to the lowered share price
- Splits also add liquidity, which makes them attractive to traders
- Many interpret splits as a sign of confidence
Some say a stock split is a good sign; it’s a sign a stock is doing well, and you should consider buying it. But it would be best if you cautioned reading too much into a split by itself.
It would be best to look at the whole picture before making any investment decision. Ultimately, you only want to buy a stock based on whether it meets your technical or fundamental criteria.
Our website has thousands of free trading courses if you’re curious about how the technical and fundamentals work.
Frequently Asked Questions
Splits can be good for the company. A lower stock price usually allows more investors to buy shares. They have other positive effects as well. For example, for indices that use price-weighted inclusion, like the Dow Jones, a stock split is a way for a company to be added. Apple is a notable company that did this when it executed a seven-for-one stock split in 2014 and was subsequently added to the Dow Jones in 2015.
Stocks stay the same after a stock split. Sometimes they will go up in price because the price of the stock becomes more affordable for traders to purchase.